High Frequency Trading and the Law

I have been an investor for most of my adult life, so I had more than just a passing interest when Michael Lewis claimed in an interview aired March 31, 2014 on 60 Minutes that the stock market was rigged in favor of high frequency traders (HFTs). Until then I had never heard of HFTs. What I learned about HFTs from Mr. Lewis in his book, Flash Boys – A Wall Street Revolt , is fascinating and astounding! HFTs, armed with high speed computer systems, operate after an order to buy/sell a stock is submitted to a stock exchange but before the stock exchange actually fills the order, a few milliseconds. No wonder I never heard of HFTs before now; why would I care what happens in those few milliseconds? All I cared about was whether my order was filled at the best market price which I had naively assumed happened routinely as the law required. See Wikipedia for the history of high frequency trading

HFTs spend enormous sums to configure and constantly update their computer systems with the latest high speed hardware and software and, importantly, to locate that hardware in close proximity (time-wise) to the public exchange computers that match buy and sell orders. This investment in speed enables HFTs to acquire information about market conditions milliseconds before the investing public, which is plenty of time to front run the markets to the advantage of the HFTs at the expense of the investing public. Front running generates millions of unnecessary trades and in the process diverts billions of dollars of investor funds into HFT coffers annually. Read Flash Boys for a detailed and documented explanation of front running as practiced by HFTs.

Many Wall Street insiders understood how HFTs ripped off the investing public but went along and kept silent out of short-sighted self-interest because they were profiting from the heightened trading activity generated by HFTs …. until one day when Mr. Brad Katsuyama, head of trading operations at Royal Bank of Canada (RBC), decided enough is enough! Mr. Katsyama quit his lucrative job at RBC to form the IEX stock exchange which opened on October 25, 2013 and is proving every day since then that public stock exchanges can run just fine without HFTs and their predatory high-speed trading practices. Read Flash Boys to understand the role Mr. Katsuyama played in jolting the world’s stock market money managers out of their historical complacency and silence.

Front running is clearly undesirable, but is it illegal? Wikipedia says, “Front running is the illegal practice of a stockbroker executing orders on a security for its own account while taking advantage of advance knowledge of pending orders from its customers.” In addition to begging the question, the analogy to stockbrokers does not fit because HFTs are not stockbrokers; they have no customers or clients and they trade exclusively for their own accounts. HFTs are not investors either because they rarely hold a stock position at the end of the trading day. HFTs are simply gamers who play the stock markets in much the same way card-counters in a casino play blackjack. In the wake of Flash Boys, the U.S. Attorney General, New York Attorney General, FBI and the Securities and Exchange Commission have launched investigations into high frequency trading.

When I was practicing corporate law, I learned something about the illegal practice of insider trading – profiting from advance information not available to the public, which is exactly what front running HFTs do. Commonsense tells me that if it looks like a duck, quacks like a duck and walks like a duck, it is probably a duck. It seems to me that upon careful analysis any experienced practitioner or learned professor in the securities law arena would readily conclude that front running as practiced by HFTs constitutes illegal insider trading under current securities law.

HFTs, and the Wall Street brokers and banks that support them, have created an extremely complex public stock market with increasing, unexplained volatility and “glitches” causing many American investors to simply opt out. This unhealthy trend continues today in stock markets worldwide that are patterned after the U.S. stock market. If front running is not illegal under current law, or there is some doubt, sound public policy demands that the practice be made explicitly illegal with stiff penalties for violations.

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